DTI throws out plans for credit rate cap

By Julie Henderson

DTI officials have backed off from plans to impose a ceiling on credit interest rates as research of overseas markets suggests a cap might exclude low income borrowers. A study of overseas credit regimes and interest rate caps was conducted by the Department of Trade and Industry (DTI) to assess whether imposing a limit on the amount credit unions and loan companies would improve lower-cost access to credit for low earners. Findings now contradict that intentions, says Consumer Minister Gerry Sutcliffe, so the government has decided it will not now add a credit rate cap as this is more likely to divert consumers to “less transparent and less appropriate products, or even to illegal loan sharks”.

Experts, commissioned by the DTI, to investigate the effect of interest rate ceilings in France, Germany and the USA found:
- lenders do not provide credit for small loans repayable over a short period, forcing some low-income consumers to take out larger loans than they need;
- the choice of products is limiting and therefore in contravention of the FTI’s own competition requirements;
- extra charges are imposed on some low earners that are not included in the interest rate calculation, but which low income consumers are particularly likely to incur, such as late payment charges; and
- the percentage of consumers who admitted to having borrowed from unlicensed or illegal lenders was twice as high in Germany and France as in the UK because they were unable to gain affordable credit any other way.

Further analysis of the Republic of Ireland’s 200% loan rate cap found lenders do not offer access to short-term borrowing rates in order to ensure they stay within the ceiling. A review of the UK credit market access is being conducted as part of the DTI’s reform of the Consumer Credit Act 1974, because their own evidence suggests lower earners are often paying substantially more for loans given the time money is required, the lower amounts borrowed and their ability to repay. Part of the move to improve borrowing conditions for lower earners includes the proposed regulation of credit unions serving the local community. Local authorities will then be given powers to prosecute illegal loan sharks. Teresa Perchard, Director of Policy, Citizens Advice Bureau responded to the DTI’s decision by pointing out the concept of extortionate credit is usually about more than the interest rate of a credit card or loan. “High pressure selling, unfair terms and conditions, hefty charges for letters and statements, expensive add-ons like insurance can all hide behind an interest rate,” says Perchard. "We hope to see the Government's other reforms of the consumer credit market given a high priority and taken forward as quickly as possible." Six months ago, the Treasury Select Committee came up with its own proposals to improve transparency of the credit and store card market, which asked credit companies to make clear in a summary box what its credit charges are, along with any other charges and essential information, to try and help consumers understand how much interest they are actually paying.

A little interest in rates could ease the pain

Credit cards will stay costly until users start looking for better deals, writes Peter Martin.

There's something about the way we use credit cards that doesn't make sense - even to some within the credit card industry. Rohan Gamble is the managing director of Virgin Money in Australia. He says he "can't fathom why" the big card providers haven't been subject to the same sort of consumer pressure to cut their rates as have the banks when it comes to home loans. Figures prepared for Virgin by BIS Shrapnel show that while the Reserve Bank's official interest rate has plunged over the past eight years (taking mortgage rates down with it) the rates charged on the major credit cards have scarcely fallen. Some of the rates have actually climbed. It is as if we don't shop around on the basis of the rates when it comes to choosing our cards. Certainly, that's been my experience. I was stopped at Sydney Airport by a woman offering me one of the new transparent blue American Express credit cards. I signed up, only to notice later that the annual interest rate was 19.9 per cent. I'm not alone. When a company in the United States renamed one of its cards the "Elvis card" it received three times the usual response.

This stupidity - if that's the word for it - both intrigues and frightens economists. It suggests that at least when it comes to credit cards, one of the fundamental tenets of economic theory doesn't apply and that there's no reward for cutting prices. Professor Lawrence Ausubel of the University of Maryland in the US has come up with an explanation. It involves what he calls "a very specific form of irrationality". Ausubel believes that there are two quite different types of credit card customers: those who believe that they will pay their bills off in time, and those who know that they won't. The first group of customers are beloved by the banks: partly because they are good credit risks (they are able to pay off their credit cards on time) and partly because being human, they often fall behind in their payments anyway. Roughly half of all US families using cards think they "nearly always pay in full", while at the same time about three-quarters of all active accounts are overdue. And the banks love this deluded group of customers for another reason as well. When they sign up for their cards, they genuinely don't care what the interest rate will be. Why should they, when they don't intend to pay it? (Some in this group might even welcome a card with a high interest rate. It would give them an incentive to make sure they paid on time.)

The way to compete for these valuable if often misled group of customers is through anything other than a low interest rate. They offer service, convenience, rewards and image. That's what I was promised at the airport. The second group of customers are different. The rate of interest is about the only thing that matters to them. They are people who know that they are going to get into debt and stay in debt, month after month. In many cases, they will be unable to get out of debt. In the industry they are known as "revolvers". They are by definition worse credit risks. So what would happen to a credit card provider that decided to strike out on its own and grab more business by cutting its rates? In Ausubel's view it would gain hardly any more of the deluded desirables. Instead it would be flooded with applications from high-risk revolvers. Slashing rates might mean commercial suicide. Even short-term low-interest honeymoon rates have their risks. They can attract revolvers who "card surf", jumping from one short-term low rate to another.

Economists at Australia's Reserve Bank examined our credit card market some years ago and found circumstantial evidence for the sort of effect that Ausubel was describing. They concluded that in those circumstances there might be a case for government intervention to force rates lower. Doubtless to the relief of Australia's major banks our Reserve Bank took the idea no further. And it now looks as if it won't need to. Virgin Money is acting as if it has never heard of Ausubel, and Gamble confirmed to me this week that he hadn't. He says by competing primarily on the basis of a good interest rate (12.4 per cent) he's been able to grab 400,000 customers from Australia's major banks in just over a year - 100,000 of them from the Commonwealth Bank. He says the thing that's astounded him is that the Commonwealth Bank hasn't fought back with a lower rate of its own. Instead it and the other banks have upped their advertising. "There are now seven credit card ads on television. All of them promote an image. None focus on the rate." It is as if the established banks are sitting back waiting for the upstart to fail, buried under a mountain of less than desirable "revolvers". Gamble insists this isn't happening. "Our customers have the same profile as those of the existing banks: an average age of 40, a broad spread of demographics and so on." It might be that things are changing. Some of the desirable deluded customers may be wising up. Four years ago, 80 per cent of Australian credit card bills were outstanding at any one time. Today the figure is a more prudent 75 per cent.

Mortgage brokers and specialist websites have made it respectable to shop around for mortgage rates. Those same websites offer information about credit card rates. Virgin says it is lobbying the authorities to require card companies to include an honesty box in their advertising outlining the actual cost of using their cards, in the same way as the mobile phone companies are required to do. Time may be running out for the "happy idiots", blissfully unaware of how much they are enriching their credit card companies, too lazy to shop around and not believing that it matters. It's up to us.

Peter Martin is the economics correspondent for SBS Television. Ross Gittins is on leave.

moneysupermarket.com responds to John McFall assessing progress into the transparency of credit card charges

moneysupermarket.com responds to John McFall assessing progress into the transparency of credit card charges

In response to John McFall, Chairman of the Treasury Select Committee assessing progress into the transparency of credit card charges, Stuart Glendinning, director of credit cards at moneysupermarket.com had this to say:

(PRWEB) August 1, 2004 -- "There are some useful points in terms of simplifying the summary box and improving the information supplied with the monthly statements and ensuring the payment protection insurance is only sold to those who may benefit from it. However, there is a hectoring tone to the letter and it seems like another example of providers being subjected to pressure to simplify and standardise how they sell their products.

"From my perspective, I cannot see why providers should be forced to share data on customers with other credit card companies. Personally, I would not want my credit card provider to share details about my circumstances with other companies that I do not conduct business with.

"As ever, the onus should be on the consumer to understand the products they are taking advantage of and sites like moneysupermarket.com represent an excellent way for the consumers to stay empowered."

moneysupermarket.com is a website where consumers can compare the cost of 1000s of personal finance products and save money. Stuart Glendinning is a director of moneysupermarket and is an independent commentator on the credit card sector [http://www.moneysupermarket.com/cards/credit_card.asp]